Dec. 31 so that all unrealized gains and losses
at year-end would be recognized for tax purposes.

This would apply whether or not the
derivative or the referenced asset were publicly traded. It would
apply not only to actual derivatives but also to investments with
embedded options.

As an example, one specific proposal would
direct taxpayers to value the call option embedded in a
convertible bond each year and then pay tax on any appreciation in
this theoretical option. How one might go about coming up with
that value is beyond me.

Derivatives are defined to include options,
future contracts, forwards and swaps. The definition also would
tax short sales as derivatives.

The actual language defines a derivative as
any “evidence of an interest in” a referenced asset such as a
stock or stock index. It is thought that the proposals weren't
meant to include ownership of the actual stock.

However, at a recent American Bar
Association meeting, the banter got exciting as prominent
attorneys and government speakers ruminated on what “evidence of
an interest in” might encompass.

Clearly, American depository receipts would
be marked to market.

One lawyer said that he was concerned that
if shares were lent out of a margin account, the investor would
end up owning a derivative rather than a stock.

Providing no comfort, Karl Walli, senior
counsel in the Treasury Department's Office of Tax Legislative
Counsel, answered, “Economically, a securities-lending transaction
has always been a derivative.”

Matthew Stevens, a partner at Ernst &
Young, pointed out that investors don't hold actual shares but
have a brokerage statement that is “evidence of an interest in”
shares that reside at a depository.

He doesn't think that was what was
intended, nor does he think a law to that effect would be passed.

Taxpayers would be instructed to act as if
the shares were sold when an investor entered a derivative.

For example, let's say you buy a stock at
$10 and watch it rise to $25. You decide to sell a call option
with a strike price of $30, but in doing that, you create a
taxable event of the shares as if you had sold them at $25.

This doesn't seem equitable and would
“kill” covered-call writing.

If these derivatives rules were passed,
futures and broad-based index options no longer would be taxed as
60% long term and 40% short term, though they still would be
marked to market at year-end.

I think that the real target of these
derivatives proposals are exchange-traded notes.

The Investment Company Institute has been
gunning for ETNs for years, and marking them to market at year-end
would remove what ICI considers ETNs' unfair tax advantage over
mutual funds.

I don't agree with Daniel Crowley, a former
lobbyist for the ICI, who said that without the tax advantage,
“there would be no reason for [ETNs] to exist.”

The notes eliminate tracking error and are
very useful when accessing difficult asset classes that don't fit
neatly into exchange-traded funds or open-end funds, such as
master limited partnerships.

I worry most about the suggestion to force
investors to use an average cost basis in computing gain or loss
when exiting a position. Investors currently can use specific lot
identification when they dispose of only a portion of their
securities holdings.

This idea was first floated by the Clinton
administration in 1996 and again in 1997. It was estimated that
the change would bring in $1 billion a year and not require
lengthy debate or legislation to be implemented.

Because of this, I'm concerned that it may
be adopted in the search for revenue. When it was offered in the
1990s, members of the securities and mutual fund industries
testified about the negative consequences; they and others could
lend their voices again.

The committee's proposals include adding a
related-party rule to the wash sale rule, and changing the
taxation of distressed debt.